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How Might Increases in the Fed Funds Rate Impact Other Interest Rates?

Monday, October 9, 2017

fed funds rate

By Fernando Martin, Senior Economist

The Federal Reserve’s main instrument for achieving stable prices and maximum employment is the target for the federal funds rate. The idea is that by affecting the rate at which banks lend to each other overnight, other interest rates may be affected. In turn, this would also affect nominal variables (such as inflation) and real variables (such as output and employment).

In December 2015, the Fed ended seven years of near-zero policy rates. Through a series of increases since then, the target rate has been gradually raised by one percentage point. The current monetary policy outlook, as stated recently by Fed Chair Janet Yellen, is to continue increasing the target rate due to worries that a strong labor market may create inflationary pressures.1

Questions about Rate Increase Impacts

The fed funds rate is thus expected to continue rising in the near future. This would undoubtedly mean that other short-term interest rates will increase in tandem.

But what about long-term interest rates? What would the impact be on those rates that arguably matter the most for real economic activity, such as mortgages rates, Treasury bond yields and corporate bond yields?

The future is always hard to predict, but we can take an educated guess by looking at the recent behavior of short-term and long-term interest rates, and how they move with the fed funds rate.

Impact on Treasury Yields

The figure below displays three key interest rates over a period of 30 years:

  • The federal funds rate
  • The interest rate on a one-year Treasury bond
  • The interest rate on a 10-year Treasury bond

As we can see, the fed funds rate and the one-year Treasury rate track each other very closely. Although it is still debatable whether the Fed leads or follows the market, movements in the policy rate are associated with similar movements in short-term interest rates.2

In contrast, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. While there appears to be some co-movement, the 10-year interest rate appears to follow its own declining path.3

Impact on Mortgage Rates

Is the interest rate on a 10-year Treasury bond representative of long-term interest rates? The next figure compares this rate to the average rate on a 30-year mortgage.

Clearly, the two move very closely together, though there is a difference in level due to the higher risk, lower liquidity and longer term of mortgages. If we were instead to look at other long-term interest rates, such as the average rate on corporate bonds, the results would be similar.

Impact on the Yield Curve

Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.4 The next figure compares the fed funds rate with the difference between 10-year and one-year Treasury bond rates.

This difference is meant to represent the yield curve at each moment in time with a single number. Note that there is a strong negative correlation between the fed funds rate and the term premium of Treasury bonds. When the policy rate increases, the spread between one- and 10-year Treasury bonds decreases.

Although it is still too early to tell, this pattern appears to be present in the latest period of interest rate hikes.

Overall Impact of Fed Funds Rate Target Increases

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.

There is, of course, the possibility that some unforeseen and fundamental change in the economy will drive long-term interest rates up, but this increase would unlikely be driven by monetary policy alone.

Notes and References

1 For example, see Appelbaum, Binyamin. “Janet Yellen Says Fed Plans to Keep Raising Rates,” New York Times, Sept. 26, 2017.

2 The interest rate on a three-month Treasury bond would look even more similar to the fed funds rate.

3 For further analysis on these trends, see Martin, Fernando M. “A Perspective on Nominal Interest Rates,” Economic Synopses, No. 25, 2016.

4 The yield curve plots interest rates as a function of maturity dates.

Additional Resources

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